12
Reporting Season Wrap & Outlook September 2017
Reporting SeasonWrap & Outlook
September 2017
1
Reporting Season Wrap & Outlook
Summary
>> FY17 delivered 18% earnings growth but was reliant on Resources to do so, with Industrials more subdued.
>> Corporate Australia continues to exercise capital discipline, supporting improved free cash flow, de-leveraging, and capital return to shareholders.
>> Disruptive and cyclical challenges remain a defining feature of the market, with a swathe of blue-chips facing an unusually uncertain outlook.
>> A pickup in capital expenditure, a controlled slowdown in housing and the imminent pipeline of infrastructure spending suggest an improvement in the broader economic landscape.
>> The equity market retains degrees of support from liquidity and dividend yield, with lucrative opportunities available to the engaged, active and agile investor.
A period of amplified uncertainty, replete with disruptive challenges, provides a fertile environment for active management.
2
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Food & Beverages
Mining
Infrastructure
Retailing – Food
Energy
REITs
Divers. Financials
Utilities
Casinos & Gaming
Health Care
Media
Transport Services
Retailing – Non-food
Banks
Building Materials
Insurance
Telecom
-1.5
-1.5
-1.2
0.6
0.6
1.3
3.9
1.2
1.3
4.1
FY18 EPS change
-10 -8 -6 -4 -2 0 2 4 6 8 10
%
Return
4.2
4.8
8.4
9.7
1.6
1.9
-1.4
-1.6
-2.4
-0.2
-0.3
-0.40.1
-4.6
-5
-5.4
-5.6
-7.5
-3.6
-4.4
-3.1
-2.8
-3.8
-4.3
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15
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17
3%
2%
1%
0%
-1%
-2%
-3%
-4%
1.5
1.4
1.3
1.2
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1
0.9
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120%
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40,000
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0
-5,000
Average = - 0.9%
FY94
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FY0
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Aug-17 -0.4%
0
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5
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8
9
FCF margin (median)
1.0
1.5
2.0
2.5
3.0
3.5
Net debt / EBITDA (index average)
Median
Source: Goldman Sachs, Factset September 2017
2011 2013 2016 2017
EBITDA Capital expenditure Free cash flow
Source: UBS, September 2017
12 M
onth
forw
ard
P/E
rela
tive
12M Fwd rel P/E -2 STD
-1 STD +1 STD
+2 STD
12M Fwd rel P/E -2 STD
-1 STD +1 STD
+2 STD
12M Fwd rel P/E -2 STD
-1 STD +1 STD
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P/E
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-4%
-2%
0%
2%
4%
6%
8%
10%
Aug-17 +5.8%
Chart 1: ASX 200 EPS upgrades/downgrades for FY17
Source: Credit Suisse, Factset, September 2017
1) Strong headline, but patchy underneath
If there was one word to encapsulate the reporting season, it is “scrappy”. At the headline level earnings-per-share (EPS) growth of 18% for the market in FY17 is one of the best results in recent times. However, this masks the stark divergence between Resources and Industrials – with the former delivering the vast bulk of growth on the back of high commodity prices. Industrials, crimped by muted revenue growth on one hand and higher input costs on the other, delivered a more subdued 4% growth.
Guidance for FY18 was somewhat lacklustre. Roughly 40% of companies saw their consensus earnings outlook downgraded by more than 2% during reporting season. While this is not a dramatic increase on the 36% which saw downgrades at the same time last year, neither is it a step in the right direction. Roughly 21% of companies did see an upgrade of greater than 2% in consensus earnings. This is higher than the 17% in the corresponding period last year, however the fact remains that almost twice the number of companies were downgraded than upgraded.
Key themes of the season
Overall FY18 EPS growth expectation for the ASX 200 were downgraded by 0.4% to 7.0%. This is a return to normality after the upgrades of February’s reporting season. Markets tend to exhibit optimism running up to results, with subsequent downward revisions are typical when expectations are tempered by reality. As illustrated in chart 1, this season’s downward revisions are less than the long-term average of -0.9% although, again, this is skewed by the Resources sector. Aggregate downgrades ran at -0.8% once the miners are stripped out, a touch worse than the long-term average of -0.7%.
The upshot is a reporting season which was not disastrous, yet which does little to encourage hope of a strong surge in earnings growth over the next year or so. We remain in a low return environment with EPS growth running in the mid-single digits.
3
Reporting Season Wrap & Outlook
Chart 2: Free cash flow (FCF)/sales
Chart 3: Net debt/EBITDA
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Mining
Infrastructure
Retailing – Food
Energy
REITs
Divers. Financials
Utilities
Casinos & Gaming
Health Care
Media
Transport Services
Retailing – Non-food
Banks
Building Materials
Insurance
Telecom
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FY18 EPS change
-10 -8 -6 -4 -2 0 2 4 6 8 10
%
Return
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FCF margin (median)
1.0
1.5
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2.5
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3.5
Net debt / EBITDA (index average)
Median
Source: Goldman Sachs, Factset September 2017
2011 2013 2016 2017
EBITDA Capital expenditure Free cash flow
Source: UBS, September 2017
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onth
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Aug-17 +5.8%
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Food & Beverages
Mining
Infrastructure
Retailing – Food
Energy
REITs
Divers. Financials
Utilities
Casinos & Gaming
Health Care
Media
Transport Services
Retailing – Non-food
Banks
Building Materials
Insurance
Telecom
-1.5
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FY18 EPS change
-10 -8 -6 -4 -2 0 2 4 6 8 10
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Return
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-0.40.1
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Aug-17 -0.4%
0
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5
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7
8
9
FCF margin (median)
1.0
1.5
2.0
2.5
3.0
3.5
Net debt / EBITDA (index average)
Median
Source: Goldman Sachs, Factset September 2017
2011 2013 2016 2017
EBITDA Capital expenditure Free cash flow
Source: UBS, September 2017
12 M
onth
forw
ard
P/E
rel
ativ
e
12M Fwd rel P/E -2 STD
-1 STD +1 STD
+2 STD
12M Fwd rel P/E -2 STD
-1 STD +1 STD
+2 STD
12M Fwd rel P/E -2 STD
-1 STD +1 STD
+2 STD
12M Fwd rel P/E -2 STD
-1 STD +1 STD
+2 STD
12 M
onth
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P/E
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12 M
onth
forw
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P/E
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12 M
onth
forw
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P/E
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-4%
-2%
0%
2%
4%
6%
8%
10%
Aug-17 +5.8%
2) Strong free cash flow underpins capital return and improved balance sheets
There are some positive highlights on this otherwise unexciting canvass, one being the persistent focus on free cash flow which is driving debt reduction and capital return to the shareholder. Many companies have proved adept at cutting costs and capital expenditure, allowing them to increase cash flow despite muted revenue growth.
Chart 2 illustrates the surge in free cash flow margin since the GFC as companies have been increasingly receptive to market demands for capital allocation discipline, investing only where there is an adequate return. This is important because, in the absence of sufficiently attractive investment opportunities, companies have been returning a portion of this excess cash to the shareholder. In an environment of low returns from other asset classes with investors starved of income, a focus on capital return via dividends and buybacks, underpinned by hefty free cash flow, provides an important degree of support for equity markets.
Yet it is not all coming back to the shareholder; companies are also using cash flow to pay down debt. Chart 3 illustrates the degree to which the market average ratio of net debt/EBITA has fallen from 2.5x at the GFC, to less than 2.0x today. This too is positive for equities, as a lower level of balance sheet risk can help support a higher valuation multiple for the market.
3) Disruptive and cyclical challenges persist
We have emphasised the unprecedented nature of the disruptive winds sweeping corporate Australia for some time now; this reporting season demonstrated that they have not waned. The market continues to grapple with the implications of Aldi in supermarkets, Netflix in media, and the probable arrival of Amazon Prime. However, this season illustrated the potentially disruptive nature of public scrutiny and government intervention.
For example, the Commonwealth Bank (CBA) saw an otherwise decent result swamped by the tide of negative public opinion over news that it had allegedly breached anti-money laundering legislation and would be subject to an Australian Prudential Regulation Authority (APRA) inquiry. CBA stock fell almost 7% for the month. Telstra (TLS), too, was weak as it adjusts in the transition from
Source: Goldman Sachs, Factset, September 2017
Source: Goldman Sachs, Factset, September 2017
4
an infrastructure company to a service provider in an intensely competitive space. It saw the Government-owned NBN Co scupper its plan to securitise and extract value from the ongoing payment stream for its relinquished pipes and copper. Meanwhile electricity company AGL (AGL) found itself focused on defending its credentials as a good corporate citizen in the face of intense government and public scrutiny over the high price of power.
There were some cyclical issues, too. Insurance companies such as Insurance Australia Group (IAG) and Suncorp (SUN) disappointed the market’s expectation of an improvement in margins and earnings. There are several headwinds to this including, again, government and public scrutiny of premiums which is limiting their ability to reprice. The introduction of new technology in cars is also rendering even minor bumper collisions more expensive to repair, inflating claims costs.
The upshot, when coupled with the challenges facing retail-related names such as Scentre Group (SCG) and Westfield (WFD) and also diversified financials such as AMP (AMP), is that a broad swathe of Australia’s best known and widely-held stocks are facing an unprecedented level of uncertainty. We see this as a potential opportunity.
Sector performanceChart 4 illustrates that the worst performing sectors over the reporting season (21 July – 31 August) – Building Materials, Insurance and Telecommunication Services – delivered large downgrades to FY18 EPS; an intuitive outcome. However it gets more interesting where the correlation between these two factors breaks down. Health care, for example, saw significant downgrades yet investors were more forgiving on the belief that these are short-term issues.
Few sectors saw material upgrades to FY18 earnings expectations. Transport Services was one that did, largely courtesy of Qantas. However it was interesting to note that it was not rewarded for this, declining 3.0% over the reporting season, although there was probably a degree of profit taking given the strong run into the results.
Ultimately, the best sector performance over the last month has come largely from re-rating. Better commodity prices boosted the Energy and Mining sectors, while Treasury Wine Estates (TWE) persuaded the market to look through a relatively weak FY18 to the promise of an improved FY19, supporting the Food and Beverage sector.
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Divers. Financials
Utilities
Casinos & Gaming
Health Care
Media
Transport Services
Retailing – Non-food
Banks
Building Materials
Insurance
Telecom
-1.5
-1.5
-1.2
0.6
0.6
1.3
3.9
1.2
1.3
4.1
FY18 EPS change
-10 -8 -6 -4 -2 0 2 4 6 8 10
%
Return
4.2
4.8
8.4
9.7
1.6
1.9
-1.4
-1.6
-2.4
-0.2
-0.3
-0.40.1
-4.6
-5
-5.4
-5.6
-7.5
-3.6
-4.4
-3.1
-2.8
-3.8
-4.3
Feb
07
Aug
07
Feb
08
Aug
08
Feb
08
Aug
09
Feb
10
Aug
10
Feb
11
Aug
11
Feb
12
Aug
12
Feb
13
Aug
13
Feb
14
Aug
14
Feb
15
Aug
15
Feb
16
Aug
16
Feb
17
Aug
17
Sep
07
Apr
08
Nov
09
Jan
10
Aug
10
Mar
11
Oct
11
May
12
Dec
12
Jul 1
3
Feb
14
Sep
14
Apr
15
Nov
15
Jun
16
Jan
17
Aug
17
Aug
14
Oct
14
Dec
14
Feb
15
Apr
15
Jun
15
Aug
15
Oct
15
Dec
15
Feb
16
Apr
16
Jun
16
Aug
16
Oct
16
Dec
16
Feb
17
Apr
17
Jun
17
Aug
17
Sep
07
May
08
Jan
09
Sep
09
May
10
Jan
11
Sep
11
May
12
Jan
13
Sep
13
May
14
Jan
15
Sep
15
May
16
Jan
17
Sep
17
Jan
12
May
12
Sep
12
Jan
13
May
13
Sep
13
Jan
14
May
14
Sep
14
Jan
15
May
15
Sep
15
Jan
16
May
16
Sep
16
Kam
17
May
17
Sep
17
3%
2%
1%
0%
-1%
-2%
-3%
-4%
1.5
1.4
1.3
1.2
1.1
1
0.9
0.8
0.7
0.6
1.5
1.4
1.3
1.2
1.1
1
0.9
0.8
0.7
1.5
1.4
1.3
1.2
1.1
1
0.9
0.8
0.7
0.6
1.4
1.3
1.2
1.1
1
0.9
0.8
0.7
0.6
120%
110%
100%
90%
80%Ja
n-95
Jan-
97
Jan-
99
Jan-
01
Jan-
03
Jan-
05
Jan-
07
Jan-
09
Jan-
11
Jan-
13
Jan-
15
Jan-
17
40,000
35,000
30,000
25,000
20,000
15,000
10,000
5,000
0
-5,000
Average = - 0.9%
FY94
FY95
FY96
FY97
FY98
FY99
FY0
0
FY0
1
FY0
2
FY0
3
FY0
4
FY0
5
FY0
6
FY0
7
FY0
8
FY0
9
FY10
FY11
FY12
FY13
FY14
FY15
FY16
FY17
FY94
FY95
FY96
FY97
FY98
FY99
FY0
0
FY0
1
FY0
2
FY0
3
FY0
4
FY0
5
FY0
6
FY0
7
FY0
8
FY0
9
FY10
FY11
FY12
FY13
FY14
FY15
FY16
FY17
Aug-17 -0.4%
0
1
2
3
4
5
6
7
8
9
FCF margin (median)
1.0
1.5
2.0
2.5
3.0
3.5
Net debt / EBITDA (index average)
Median
Source: Goldman Sachs, Factset September 2017
2011 2013 2016 2017
EBITDA Capital expenditure Free cash flow
Source: UBS, September 2017
12 M
onth
forw
ard
P/E
rela
tive
12M Fwd rel P/E -2 STD
-1 STD +1 STD
+2 STD
12M Fwd rel P/E -2 STD
-1 STD +1 STD
+2 STD
12M Fwd rel P/E -2 STD
-1 STD +1 STD
+2 STD
12M Fwd rel P/E -2 STD
-1 STD +1 STD
+2 STD
12 M
onth
forw
ard
P/E
rela
tive
12 M
onth
forw
ard
P/E
rel
ativ
e
12 M
onth
forw
ard
P/E
rel
ativ
e
-4%
-2%
0%
2%
4%
6%
8%
10%
Aug-17 +5.8%
Source: IBES, S&P, MSCI, Datastream, Citi Research. Note IBES data up to 31 August 2017.
Chart 4: Sector performance & FY18 earnings change in reporting season
5
Reporting Season Wrap & Outlook
Feb-
04
Aug
-04
Feb-
05
Aug
-05
Feb-
06
Aug
-06
Feb-
07
Aug
-07
Feb-
08
Aug
-08
Feb-
09
Aug
-09
Feb-
10
Aug
-10
Feb-
11
Aug
-11
Feb-
12
Aug
-12
Feb-
13
Aug
-13
Feb-
14
Aug
-14
Feb-
15
Aug
-15
Feb-
16
Aug
-16
Feb-
17
Aug
-17
Food & Beverages
Mining
Infrastructure
Retailing – Food
Energy
REITs
Divers. Financials
Utilities
Casinos & Gaming
Health Care
Media
Transport Services
Retailing – Non-food
Banks
Building Materials
Insurance
Telecom
-1.5
-1.5
-1.2
0.6
0.6
1.3
3.9
1.2
1.3
4.1
FY18 EPS change
-10 -8 -6 -4 -2 0 2 4 6 8 10
%
Return
4.2
4.8
8.4
9.7
1.6
1.9
-1.4
-1.6
-2.4
-0.2
-0.3
-0.40.1
-4.6
-5
-5.4
-5.6
-7.5
-3.6
-4.4
-3.1
-2.8
-3.8
-4.3
Feb
07
Aug
07
Feb
08
Aug
08
Feb
08
Aug
09
Feb
10
Aug
10
Feb
11
Aug
11
Feb
12
Aug
12
Feb
13
Aug
13
Feb
14
Aug
14
Feb
15
Aug
15
Feb
16
Aug
16
Feb
17
Aug
17
Sep
07
Apr
08
Nov
09
Jan
10
Aug
10
Mar
11
Oct
11
May
12
Dec
12
Jul 1
3
Feb
14
Sep
14
Apr
15
Nov
15
Jun
16
Jan
17
Aug
17
Aug
14
Oct
14
Dec
14
Feb
15
Apr
15
Jun
15
Aug
15
Oct
15
Dec
15
Feb
16
Apr
16
Jun
16
Aug
16
Oct
16
Dec
16
Feb
17
Apr
17
Jun
17
Aug
17
Sep
07
May
08
Jan
09
Sep
09
May
10
Jan
11
Sep
11
May
12
Jan
13
Sep
13
May
14
Jan
15
Sep
15
May
16
Jan
17
Sep
17
Jan
12
May
12
Sep
12
Jan
13
May
13
Sep
13
Jan
14
May
14
Sep
14
Jan
15
May
15
Sep
15
Jan
16
May
16
Sep
16
Kam
17
May
17
Sep
17
3%
2%
1%
0%
-1%
-2%
-3%
-4%
1.5
1.4
1.3
1.2
1.1
1
0.9
0.8
0.7
0.6
1.5
1.4
1.3
1.2
1.1
1
0.9
0.8
0.7
1.5
1.4
1.3
1.2
1.1
1
0.9
0.8
0.7
0.6
1.4
1.3
1.2
1.1
1
0.9
0.8
0.7
0.6
120%
110%
100%
90%
80%
Jan-
95
Jan-
97
Jan-
99
Jan-
01
Jan-
03
Jan-
05
Jan-
07
Jan-
09
Jan-
11
Jan-
13
Jan-
15
Jan-
17
40,000
35,000
30,000
25,000
20,000
15,000
10,000
5,000
0
-5,000
Average = - 0.9%
FY94
FY95
FY96
FY97
FY98
FY99
FY0
0
FY0
1
FY0
2
FY0
3
FY0
4
FY0
5
FY0
6
FY0
7
FY0
8
FY0
9
FY10
FY11
FY12
FY13
FY14
FY15
FY16
FY17
FY94
FY95
FY96
FY97
FY98
FY99
FY0
0
FY0
1
FY0
2
FY0
3
FY0
4
FY0
5
FY0
6
FY0
7
FY0
8
FY0
9
FY10
FY11
FY12
FY13
FY14
FY15
FY16
FY17
Aug-17 -0.4%
0
1
2
3
4
5
6
7
8
9
FCF margin (median)
1.0
1.5
2.0
2.5
3.0
3.5
Net debt / EBITDA (index average)
Median
Source: Goldman Sachs, Factset September 2017
2011 2013 2016 2017
EBITDA Capital expenditure Free cash flow
Source: UBS, September 2017
12 M
onth
forw
ard
P/E
rela
tive
12M Fwd rel P/E -2 STD
-1 STD +1 STD
+2 STD
12M Fwd rel P/E -2 STD
-1 STD +1 STD
+2 STD
12M Fwd rel P/E -2 STD
-1 STD +1 STD
+2 STD
12M Fwd rel P/E -2 STD
-1 STD +1 STD
+2 STD
12 M
onth
forw
ard
P/E
rela
tive
12 M
onth
forw
ard
P/E
rela
tive
12 M
onth
forw
ard
P/E
rel
ativ
e
-4%
-2%
0%
2%
4%
6%
8%
10%
Aug-17 +5.8%
Chart 5 BHP – 4 phases of strategy
ResourcesWe retain our positive view on resources post the reporting season. Chinese policy remains crucial and demands ongoing scrutiny, particularly as we move into a period of political transition around the National Congress in October. Investors must be engaged and agile, given the opaque nature of policy machinations. Nevertheless, while China pursues its current policy of supply side consolidation and capacity reduction – which is helping state-owned enterprises service their debt and, in turn, reducing pressure on the financial system – it remains supportive for commodity prices and the Australian mining sector.
The miners delivered a good, if unsurprising, set of results. Decent commodity prices, coupled with discipline on production volumes, costs, and capital expenditure is supporting a tide of free cash flow which is being used to pay down debt and fund dividends and share buybacks. We are seeing miners enter a new phase. BHP, for example, has not delivered free cash flow on this scale since the halcyon days of 2011, when iron ore was above US$100 per tonne (see chart 5). It – and its peers – subsequently
splurged on expanded production in the expectation that high commodity prices would persist. Thus in 2013 BHP, while generating far higher EBITDA than today, actually had negative free cash flow as capital expenditure chewed up the bulk of revenue. Commodity prices then collapsed, squeezing cash flow, and by 2016 BHP had bunkered down – slashing capital expenditure.
Now we have entered a new phase, with commodity prices tracking at a reasonable level and capital expenditure held down, supporting a recovery in free cash flow. We believe this can last for several years. Capital expenditure is likely to rise from current levels, but not to the levels of 2013. BHP also has the possibility of reducing its iron ore production costs further, particularly if it is able to divest its low-return North American onshore oil and gas assets and focus greater attention on its higher-return Pilbarra mines. The upshot is that resources should provide an attractive source of shareholder return for the next couple of years at least. Our current preference is for BHP, where management changes are likely to result in better capital allocation and the divestment of under-performing assets.
Strong commodity prices drive FCF
Capital spends removes FCF
Low commodity prices hit FCF
Capital discipline drives good FCF
in moderate price environment
Source:BTIM, Company data, September 2017
6
FinancialsBanks – and particularly CBA – found themselves on the front pages for all the wrong reasons as allegations of regulatory breaches renewed calls for greater scrutiny of banking practices and culture. The sentimental hit to bank stocks is compounded by real effects – it is likely that any measures to comply with increased regulation and oversight would come at some financial cost. Bank stocks sold off over reporting season, led by CBA’s almost 7.0% drop.
Banks are at an unusual juncture, with valuations of the “Big 4” converging for only the fourth time in 25 years (chart 6). There are material differences between the banks in terms of operating quality, business mix, strategies and earnings drivers. Yet current valuations imply that the market is not differentiating between them and is uncertain about which will do best over the next few years.
Source:BTIM, Company data, September 2017
“ Banks are at an unusual juncture, with valuations of the “Big 4” converging for only the fourth time in 25 years”
Chart 6: Bank P/E relative to the sector
Feb-
04
Aug
-04
Feb-
05
Aug
-05
Feb-
06
Aug
-06
Feb-
07
Aug
-07
Feb-
08
Aug
-08
Feb-
09
Aug
-09
Feb-
10
Aug
-10
Feb-
11
Aug
-11
Feb-
12
Aug
-12
Feb-
13
Aug
-13
Feb-
14
Aug
-14
Feb-
15
Aug
-15
Feb-
16
Aug
-16
Feb-
17
Aug
-17
Food & Beverages
Mining
Infrastructure
Retailing – Food
Energy
REITs
Divers. Financials
Utilities
Casinos & Gaming
Health Care
Media
Transport Services
Retailing – Non-food
Banks
Building Materials
Insurance
Telecom
-1.5
-1.5
-1.2
0.6
0.6
1.3
3.9
1.2
1.3
4.1
FY18 EPS change
-10 -8 -6 -4 -2 0 2 4 6 8 10
%
Return
4.2
4.8
8.4
9.7
1.6
1.9
-1.4
-1.6
-2.4
-0.2
-0.3
-0.40.1
-4.6
-5
-5.4
-5.6
-7.5
-3.6
-4.4
-3.1
-2.8
-3.8
-4.3
Feb
07
Aug
07
Feb
08
Aug
08
Feb
08
Aug
09
Feb
10
Aug
10
Feb
11
Aug
11
Feb
12
Aug
12
Feb
13
Aug
13
Feb
14
Aug
14
Feb
15
Aug
15
Feb
16
Aug
16
Feb
17
Aug
17
Sep
07
Apr
08
Nov
09
Jan
10
Aug
10
Mar
11
Oct
11
May
12
Dec
12
Jul 1
3
Feb
14
Sep
14
Apr
15
Nov
15
Jun
16
Jan
17
Aug
17
Aug
14
Oct
14
Dec
14
Feb
15
Apr
15
Jun
15
Aug
15
Oct
15
Dec
15
Feb
16
Apr
16
Jun
16
Aug
16
Oct
16
Dec
16
Feb
17
Apr
17
Jun
17
Aug
17
Sep
07
May
08
Jan
09
Sep
09
May
10
Jan
11
Sep
11
May
12
Jan
13
Sep
13
May
14
Jan
15
Sep
15
May
16
Jan
17
Sep
17
Jan
12
May
12
Sep
12
Jan
13
May
13
Sep
13
Jan
14
May
14
Sep
14
Jan
15
May
15
Sep
15
Jan
16
May
16
Sep
16
Kam
17
May
17
Sep
17
3%
2%
1%
0%
-1%
-2%
-3%
-4%
1.5
1.4
1.3
1.2
1.1
1
0.9
0.8
0.7
0.6
1.5
1.4
1.3
1.2
1.1
1
0.9
0.8
0.7
1.5
1.4
1.3
1.2
1.1
1
0.9
0.8
0.7
0.6
1.4
1.3
1.2
1.1
1
0.9
0.8
0.7
0.6
120%
110%
100%
90%
80%
Jan-
95
Jan-
97
Jan-
99
Jan-
01
Jan-
03
Jan-
05
Jan-
07
Jan-
09
Jan-
11
Jan-
13
Jan-
15
Jan-
17
40,000
35,000
30,000
25,000
20,000
15,000
10,000
5,000
0
-5,000
Average = - 0.9%
FY94
FY95
FY96
FY97
FY98
FY99
FY0
0
FY0
1
FY0
2
FY0
3
FY0
4
FY0
5
FY0
6
FY0
7
FY0
8
FY0
9
FY10
FY11
FY12
FY13
FY14
FY15
FY16
FY17
FY94
FY95
FY96
FY97
FY98
FY99
FY0
0
FY0
1
FY0
2
FY0
3
FY0
4
FY0
5
FY0
6
FY0
7
FY0
8
FY0
9
FY10
FY11
FY12
FY13
FY14
FY15
FY16
FY17
Aug-17 -0.4%
0
1
2
3
4
5
6
7
8
9
FCF margin (median)
1.0
1.5
2.0
2.5
3.0
3.5
Net debt / EBITDA (index average)
Median
Source: Goldman Sachs, Factset September 2017
2011 2013 2016 2017
EBITDA Capital expenditure Free cash flow
Source: UBS, September 2017
12 M
onth
forw
ard
P/E
rela
tive
12M Fwd rel P/E -2 STD
-1 STD +1 STD
+2 STD
12M Fwd rel P/E -2 STD
-1 STD +1 STD
+2 STD
12M Fwd rel P/E -2 STD
-1 STD +1 STD
+2 STD
12M Fwd rel P/E -2 STD
-1 STD +1 STD
+2 STD
12 M
onth
forw
ard
P/E
rela
tive
12 M
onth
forw
ard
P/E
rela
tive
12 M
onth
forw
ard
P/E
rela
tive
-4%
-2%
0%
2%
4%
6%
8%
10%
Aug-17 +5.8%
Source: UBS, September 2017
7
Reporting Season Wrap & Outlook
Other IndustrialsThe threat of Amazon Prime has ensured that the retail sector remains under close scrutiny. It is a salient example of the disruptive threats emerging in the Australian market. However for retail it goes beyond Amazon; they are beset by an additional three challenging trends. The first is changes in consumer behaviour, with emerging preferences for experiences – such as holidays and dining – over consumer goods. The second is the rise of fast fashion business models as the cycle of clothing trends has accelerated. Companies such as Zara, Uniqlo and H&M are able to quickly cycle product in and out of stores to reflect this, in a way that many domestic clothing brands, which lack the international supply chain, cannot. Finally, the stagnation of real wage growth, in combination with rising costs for electricity and the like, has seen a deterioration in consumer disposable income.
The combination of these headwinds has led to a valuation de-rating for retailers such as JB Hi-FI (JBH), Myer (MYR) and Harvey Norman (HVN). We believe that the retail sector will offer lucrative investment opportunities as this disruptive process unfolds. History tells us that markets are not inclined to differentiate between companies in episodes of significant sector stress. However observations from overseas markets suggest that there will be winners and losers in such disruptive episodes.
Chart 8: IAG 12m forward P/E relative to ASX200 Industrials
Source: BTIM, September 2017
Feb-
04
Aug
-04
Feb-
05
Aug
-05
Feb-
06
Aug
-06
Feb-
07
Aug
-07
Feb-
08
Aug
-08
Feb-
09
Aug
-09
Feb-
10
Aug
-10
Feb-
11
Aug
-11
Feb-
12
Aug
-12
Feb-
13
Aug
-13
Feb-
14
Aug
-14
Feb-
15
Aug
-15
Feb-
16
Aug
-16
Feb-
17
Aug
-17
Food & Beverages
Mining
Infrastructure
Retailing – Food
Energy
REITs
Divers. Financials
Utilities
Casinos & Gaming
Health Care
Media
Transport Services
Retailing – Non-food
Banks
Building Materials
Insurance
Telecom
-1.5
-1.5
-1.2
0.6
0.6
1.3
3.9
1.2
1.3
4.1
FY18 EPS change
-10 -8 -6 -4 -2 0 2 4 6 8 10
%
Return
4.2
4.8
8.4
9.7
1.6
1.9
-1.4
-1.6
-2.4
-0.2
-0.3
-0.40.1
-4.6
-5
-5.4
-5.6
-7.5
-3.6
-4.4
-3.1
-2.8
-3.8
-4.3
Feb
07
Aug
07
Feb
08
Aug
08
Feb
08
Aug
09
Feb
10
Aug
10
Feb
11
Aug
11
Feb
12
Aug
12
Feb
13
Aug
13
Feb
14
Aug
14
Feb
15
Aug
15
Feb
16
Aug
16
Feb
17
Aug
17
Sep
07
Apr
08
Nov
09
Jan
10
Aug
10
Mar
11
Oct
11
May
12
Dec
12
Jul 1
3
Feb
14
Sep
14
Apr
15
Nov
15
Jun
16
Jan
17
Aug
17
Aug
14
Oct
14
Dec
14
Feb
15
Apr
15
Jun
15
Aug
15
Oct
15
Dec
15
Feb
16
Apr
16
Jun
16
Aug
16
Oct
16
Dec
16
Feb
17
Apr
17
Jun
17
Aug
17
Sep
07
May
08
Jan
09
Sep
09
May
10
Jan
11
Sep
11
May
12
Jan
13
Sep
13
May
14
Jan
15
Sep
15
May
16
Jan
17
Sep
17
Jan
12
May
12
Sep
12
Jan
13
May
13
Sep
13
Jan
14
May
14
Sep
14
Jan
15
May
15
Sep
15
Jan
16
May
16
Sep
16
Kam
17
May
17
Sep
173%
2%
1%
0%
-1%
-2%
-3%
-4%
1.5
1.4
1.3
1.2
1.1
1
0.9
0.8
0.7
0.6
1.5
1.4
1.3
1.2
1.1
1
0.9
0.8
0.7
1.5
1.4
1.3
1.2
1.1
1
0.9
0.8
0.7
0.6
1.4
1.3
1.2
1.1
1
0.9
0.8
0.7
0.6
120%
110%
100%
90%
80%
Jan-
95
Jan-
97
Jan-
99
Jan-
01
Jan-
03
Jan-
05
Jan-
07
Jan-
09
Jan-
11
Jan-
13
Jan-
15
Jan-
17
40,000
35,000
30,000
25,000
20,000
15,000
10,000
5,000
0
-5,000
Average = - 0.9%
FY94
FY95
FY96
FY97
FY98
FY99
FY0
0
FY0
1
FY0
2
FY0
3
FY0
4
FY0
5
FY0
6
FY0
7
FY0
8
FY0
9
FY10
FY11
FY12
FY13
FY14
FY15
FY16
FY17
FY94
FY95
FY96
FY97
FY98
FY99
FY0
0
FY0
1
FY0
2
FY0
3
FY0
4
FY0
5
FY0
6
FY0
7
FY0
8
FY0
9
FY10
FY11
FY12
FY13
FY14
FY15
FY16
FY17
Aug-17 -0.4%
0
1
2
3
4
5
6
7
8
9
FCF margin (median)
1.0
1.5
2.0
2.5
3.0
3.5
Net debt / EBITDA (index average)
Median
Source: Goldman Sachs, Factset September 2017
2011 2013 2016 2017
EBITDA Capital expenditure Free cash flow
Source: UBS, September 2017
12 M
onth
forw
ard
P/E
rela
tive
12M Fwd rel P/E -2 STD
-1 STD +1 STD
+2 STD
12M Fwd rel P/E -2 STD
-1 STD +1 STD
+2 STD
12M Fwd rel P/E -2 STD
-1 STD +1 STD
+2 STD
12M Fwd rel P/E -2 STD
-1 STD +1 STD
+2 STD
12 M
onth
forw
ard
P/E
rela
tive
12 M
onth
forw
ard
P/E
rela
tive
12 M
onth
forw
ard
P/E
rela
tive
-4%
-2%
0%
2%
4%
6%
8%
10%
Aug-17 +5.8%
Chart 7: CBA 12m forward P/E relative to ASX200 Industrials
Source: BTIM, September 2017
Feb-
04
Aug
-04
Feb-
05
Aug
-05
Feb-
06
Aug
-06
Feb-
07
Aug
-07
Feb-
08
Aug
-08
Feb-
09
Aug
-09
Feb-
10
Aug
-10
Feb-
11
Aug
-11
Feb-
12
Aug
-12
Feb-
13
Aug
-13
Feb-
14
Aug
-14
Feb-
15
Aug
-15
Feb-
16
Aug
-16
Feb-
17
Aug
-17
Food & Beverages
Mining
Infrastructure
Retailing – Food
Energy
REITs
Divers. Financials
Utilities
Casinos & Gaming
Health Care
Media
Transport Services
Retailing – Non-food
Banks
Building Materials
Insurance
Telecom
-1.5
-1.5
-1.2
0.6
0.6
1.3
3.9
1.2
1.3
4.1
FY18 EPS change
-10 -8 -6 -4 -2 0 2 4 6 8 10
%
Return
4.2
4.8
8.4
9.7
1.6
1.9
-1.4
-1.6
-2.4
-0.2
-0.3
-0.40.1
-4.6
-5
-5.4
-5.6
-7.5
-3.6
-4.4
-3.1
-2.8
-3.8
-4.3
Feb
07
Aug
07
Feb
08
Aug
08
Feb
08
Aug
09
Feb
10
Aug
10
Feb
11
Aug
11
Feb
12
Aug
12
Feb
13
Aug
13
Feb
14
Aug
14
Feb
15
Aug
15
Feb
16
Aug
16
Feb
17
Aug
17
Sep
07
Apr
08
Nov
09
Jan
10
Aug
10
Mar
11
Oct
11
May
12
Dec
12
Jul 1
3
Feb
14
Sep
14
Apr
15
Nov
15
Jun
16
Jan
17
Aug
17
Aug
14
Oct
14
Dec
14
Feb
15
Apr
15
Jun
15
Aug
15
Oct
15
Dec
15
Feb
16
Apr
16
Jun
16
Aug
16
Oct
16
Dec
16
Feb
17
Apr
17
Jun
17
Aug
17
Sep
07
May
08
Jan
09
Sep
09
May
10
Jan
11
Sep
11
May
12
Jan
13
Sep
13
May
14
Jan
15
Sep
15
May
16
Jan
17
Sep
17
Jan
12
May
12
Sep
12
Jan
13
May
13
Sep
13
Jan
14
May
14
Sep
14
Jan
15
May
15
Sep
15
Jan
16
May
16
Sep
16
Kam
17
May
17
Sep
17
3%
2%
1%
0%
-1%
-2%
-3%
-4%
1.5
1.4
1.3
1.2
1.1
1
0.9
0.8
0.7
0.6
1.5
1.4
1.3
1.2
1.1
1
0.9
0.8
0.7
1.5
1.4
1.3
1.2
1.1
1
0.9
0.8
0.7
0.6
1.4
1.3
1.2
1.1
1
0.9
0.8
0.7
0.6
120%
110%
100%
90%
80%
Jan-
95
Jan-
97
Jan-
99
Jan-
01
Jan-
03
Jan-
05
Jan-
07
Jan-
09
Jan-
11
Jan-
13
Jan-
15
Jan-
17
40,000
35,000
30,000
25,000
20,000
15,000
10,000
5,000
0
-5,000
Average = - 0.9%
FY94
FY95
FY96
FY97
FY98
FY99
FY0
0
FY0
1
FY0
2
FY0
3
FY0
4
FY0
5
FY0
6
FY0
7
FY0
8
FY0
9
FY10
FY11
FY12
FY13
FY14
FY15
FY16
FY17
FY94
FY95
FY96
FY97
FY98
FY99
FY0
0
FY0
1
FY0
2
FY0
3
FY0
4
FY0
5
FY0
6
FY0
7
FY0
8
FY0
9
FY10
FY11
FY12
FY13
FY14
FY15
FY16
FY17
Aug-17 -0.4%
0
1
2
3
4
5
6
7
8
9
FCF margin (median)
1.0
1.5
2.0
2.5
3.0
3.5
Net debt / EBITDA (index average)
Median
Source: Goldman Sachs, Factset September 2017
2011 2013 2016 2017
EBITDA Capital expenditure Free cash flow
Source: UBS, September 2017
12 M
onth
forw
ard
P/E
rel
ativ
e
12M Fwd rel P/E -2 STD
-1 STD +1 STD
+2 STD
12M Fwd rel P/E -2 STD
-1 STD +1 STD
+2 STD
12M Fwd rel P/E -2 STD
-1 STD +1 STD
+2 STD
12M Fwd rel P/E -2 STD
-1 STD +1 STD
+2 STD12
Mon
th fo
rwar
d P
/E r
elat
ive
12 M
onth
forw
ard
P/E
rela
tive
12 M
onth
forw
ard
P/E
rela
tive
-4%
-2%
0%
2%
4%
6%
8%
10%
Aug-17 +5.8%
The irony is that this crescendo of fears has masked a decent earnings result from CBA and trading updates from its peers, as the benefits of recent mortgage rate hikes start to flow through to improved profit margins on deposit books. In combination with a benign outcome of APRA’s guidelines on capital provisions – which removed lingering concerns over dividend cuts or further equity capital raising – and a thus far controlled slowdown in the housing market, the combination of headwinds facing banks has somewhat abated.
All this comes at a point where banks are trading well below their long-term average valuations relative to the market. The valuation differential of CBA and IAG, seen as the highest-quality companies within the banking and insurance sectors respectively, is stark (charts 7 and 8). CBA is trading at a standard deviation below its long-term relative valuation, while IAG is a standard deviation above, on the previously-mentioned expectations of a pick-up in the insurance cycle.
The upshot of all this is that we see an opportunity in banks, where valuations reflect all the recent negative sentiment and none of the underlying positive trends. At the same time, we believe that the market is over-optimistic on insurance, with the current valuation rating leaving little room for any disappointment.
8
Chart 8: IAG 12m forward P/E relative to ASX200 Industrials
Feb-
04
Aug
-04
Feb-
05
Aug
-05
Feb-
06
Aug
-06
Feb-
07
Aug
-07
Feb-
08
Aug
-08
Feb-
09
Aug
-09
Feb-
10
Aug
-10
Feb-
11
Aug
-11
Feb-
12
Aug
-12
Feb-
13
Aug
-13
Feb-
14
Aug
-14
Feb-
15
Aug
-15
Feb-
16
Aug
-16
Feb-
17
Aug
-17
Food & Beverages
Mining
Infrastructure
Retailing – Food
Energy
REITs
Divers. Financials
Utilities
Casinos & Gaming
Health Care
Media
Transport Services
Retailing – Non-food
Banks
Building Materials
Insurance
Telecom
-1.5
-1.5
-1.2
0.6
0.6
1.3
3.9
1.2
1.3
4.1
FY18 EPS change
-10 -8 -6 -4 -2 0 2 4 6 8 10
%
Return
4.2
4.8
8.4
9.7
1.6
1.9
-1.4
-1.6
-2.4
-0.2
-0.3
-0.40.1
-4.6
-5
-5.4
-5.6
-7.5
-3.6
-4.4
-3.1
-2.8
-3.8
-4.3
Feb
07
Aug
07
Feb
08
Aug
08
Feb
08
Aug
09
Feb
10
Aug
10
Feb
11
Aug
11
Feb
12
Aug
12
Feb
13
Aug
13
Feb
14
Aug
14
Feb
15
Aug
15
Feb
16
Aug
16
Feb
17
Aug
17
Sep
07
Apr
08
Nov
09
Jan
10
Aug
10
Mar
11
Oct
11
May
12
Dec
12
Jul 1
3
Feb
14
Sep
14
Apr
15
Nov
15
Jun
16
Jan
17
Aug
17
Aug
14
Oct
14
Dec
14
Feb
15
Apr
15
Jun
15
Aug
15
Oct
15
Dec
15
Feb
16
Apr
16
Jun
16
Aug
16
Oct
16
Dec
16
Feb
17
Apr
17
Jun
17
Aug
17
Sep
07
May
08
Jan
09
Sep
09
May
10
Jan
11
Sep
11
May
12
Jan
13
Sep
13
May
14
Jan
15
Sep
15
May
16
Jan
17
Sep
17
Jan
12
May
12
Sep
12
Jan
13
May
13
Sep
13
Jan
14
May
14
Sep
14
Jan
15
May
15
Sep
15
Jan
16
May
16
Sep
16
Kam
17
May
17
Sep
17
3%
2%
1%
0%
-1%
-2%
-3%
-4%
1.5
1.4
1.3
1.2
1.1
1
0.9
0.8
0.7
0.6
1.5
1.4
1.3
1.2
1.1
1
0.9
0.8
0.7
1.5
1.4
1.3
1.2
1.1
1
0.9
0.8
0.7
0.6
1.4
1.3
1.2
1.1
1
0.9
0.8
0.7
0.6
120%
110%
100%
90%
80%
Jan-
95
Jan-
97
Jan-
99
Jan-
01
Jan-
03
Jan-
05
Jan-
07
Jan-
09
Jan-
11
Jan-
13
Jan-
15
Jan-
17
40,000
35,000
30,000
25,000
20,000
15,000
10,000
5,000
0
-5,000
Average = - 0.9%
FY94
FY95
FY96
FY97
FY98
FY99
FY0
0
FY0
1
FY0
2
FY0
3
FY0
4
FY0
5
FY0
6
FY0
7
FY0
8
FY0
9
FY10
FY11
FY12
FY13
FY14
FY15
FY16
FY17
FY94
FY95
FY96
FY97
FY98
FY99
FY0
0
FY0
1
FY0
2
FY0
3
FY0
4
FY0
5
FY0
6
FY0
7
FY0
8
FY0
9
FY10
FY11
FY12
FY13
FY14
FY15
FY16
FY17
Aug-17 -0.4%
0
1
2
3
4
5
6
7
8
9
FCF margin (median)
1.0
1.5
2.0
2.5
3.0
3.5
Net debt / EBITDA (index average)
Median
Source: Goldman Sachs, Factset September 2017
2011 2013 2016 2017
EBITDA Capital expenditure Free cash flow
Source: UBS, September 2017
12 M
onth
forw
ard
P/E
rela
tive
12M Fwd rel P/E -2 STD
-1 STD +1 STD
+2 STD
12M Fwd rel P/E -2 STD
-1 STD +1 STD
+2 STD
12M Fwd rel P/E -2 STD
-1 STD +1 STD
+2 STD
12M Fwd rel P/E -2 STD
-1 STD +1 STD
+2 STD
12 M
onth
forw
ard
P/E
rela
tive
12 M
onth
forw
ard
P/E
rel
ativ
e
12 M
onth
forw
ard
P/E
rela
tive
-4%
-2%
0%
2%
4%
6%
8%
10%
Aug-17 +5.8%
Feb-
04
Aug
-04
Feb-
05
Aug
-05
Feb-
06
Aug
-06
Feb-
07
Aug
-07
Feb-
08
Aug
-08
Feb-
09
Aug
-09
Feb-
10
Aug
-10
Feb-
11
Aug
-11
Feb-
12
Aug
-12
Feb-
13
Aug
-13
Feb-
14
Aug
-14
Feb-
15
Aug
-15
Feb-
16
Aug
-16
Feb-
17
Aug
-17
Food & Beverages
Mining
Infrastructure
Retailing – Food
Energy
REITs
Divers. Financials
Utilities
Casinos & Gaming
Health Care
Media
Transport Services
Retailing – Non-food
Banks
Building Materials
Insurance
Telecom
-1.5
-1.5
-1.2
0.6
0.6
1.3
3.9
1.2
1.3
4.1
FY18 EPS change
-10 -8 -6 -4 -2 0 2 4 6 8 10
%
Return
4.2
4.8
8.4
9.7
1.6
1.9
-1.4
-1.6
-2.4
-0.2
-0.3
-0.40.1
-4.6
-5
-5.4
-5.6
-7.5
-3.6
-4.4
-3.1
-2.8
-3.8
-4.3
Feb
07
Aug
07
Feb
08
Aug
08
Feb
08
Aug
09
Feb
10
Aug
10
Feb
11
Aug
11
Feb
12
Aug
12
Feb
13
Aug
13
Feb
14
Aug
14
Feb
15
Aug
15
Feb
16
Aug
16
Feb
17
Aug
17
Sep
07
Apr
08
Nov
09
Jan
10
Aug
10
Mar
11
Oct
11
May
12
Dec
12
Jul 1
3
Feb
14
Sep
14
Apr
15
Nov
15
Jun
16
Jan
17
Aug
17
Aug
14
Oct
14
Dec
14
Feb
15
Apr
15
Jun
15
Aug
15
Oct
15
Dec
15
Feb
16
Apr
16
Jun
16
Aug
16
Oct
16
Dec
16
Feb
17
Apr
17
Jun
17
Aug
17
Sep
07
May
08
Jan
09
Sep
09
May
10
Jan
11
Sep
11
May
12
Jan
13
Sep
13
May
14
Jan
15
Sep
15
May
16
Jan
17
Sep
17
Jan
12
May
12
Sep
12
Jan
13
May
13
Sep
13
Jan
14
May
14
Sep
14
Jan
15
May
15
Sep
15
Jan
16
May
16
Sep
16
Kam
17
May
17
Sep
17
3%
2%
1%
0%
-1%
-2%
-3%
-4%
1.5
1.4
1.3
1.2
1.1
1
0.9
0.8
0.7
0.6
1.5
1.4
1.3
1.2
1.1
1
0.9
0.8
0.7
1.5
1.4
1.3
1.2
1.1
1
0.9
0.8
0.7
0.6
1.4
1.3
1.2
1.1
1
0.9
0.8
0.7
0.6
120%
110%
100%
90%
80%
Jan-
95
Jan-
97
Jan-
99
Jan-
01
Jan-
03
Jan-
05
Jan-
07
Jan-
09
Jan-
11
Jan-
13
Jan-
15
Jan-
17
40,000
35,000
30,000
25,000
20,000
15,000
10,000
5,000
0
-5,000
Average = - 0.9%
FY94
FY95
FY96
FY97
FY98
FY99
FY0
0
FY0
1
FY0
2
FY0
3
FY0
4
FY0
5
FY0
6
FY0
7
FY0
8
FY0
9
FY10
FY11
FY12
FY13
FY14
FY15
FY16
FY17
FY94
FY95
FY96
FY97
FY98
FY99
FY0
0
FY0
1
FY0
2
FY0
3
FY0
4
FY0
5
FY0
6
FY0
7
FY0
8
FY0
9
FY10
FY11
FY12
FY13
FY14
FY15
FY16
FY17
Aug-17 -0.4%
0
1
2
3
4
5
6
7
8
9
FCF margin (median)
1.0
1.5
2.0
2.5
3.0
3.5
Net debt / EBITDA (index average)
Median
Source: Goldman Sachs, Factset September 2017
2011 2013 2016 2017
EBITDA Capital expenditure Free cash flow
Source: UBS, September 2017
12 M
onth
forw
ard
P/E
rela
tive
12M Fwd rel P/E -2 STD
-1 STD +1 STD
+2 STD
12M Fwd rel P/E -2 STD
-1 STD +1 STD
+2 STD
12M Fwd rel P/E -2 STD
-1 STD +1 STD
+2 STD
12M Fwd rel P/E -2 STD
-1 STD +1 STD
+2 STD
12 M
onth
forw
ard
P/E
rela
tive
12 M
onth
forw
ard
P/E
rela
tive
12 M
onth
forw
ard
P/E
rel
ativ
e
-4%
-2%
0%
2%
4%
6%
8%
10%
Aug-17 +5.8%
Chart 9: SCG 12m forward P/E relative to ASX 200 industrials
Source: Company data, IRESS, CS September 2017 Source: BTIM, September 2017
Amazon’s establishment in the US and UK has, for example, led to consolidation rather than obliteration of the existing retail industry, offering opportunities for the best run franchises. We believe the same will hold true in Australia and will look to exploit negative sentiment around this issue.
Concerns over retail have led to an interesting divergence within A-REITs. Office and industrial REITs such as Goodman Group (GMG) have re-rated in 2017 along with other bond-sensitive stocks such as infrastructure, as expectations of bond yield increases have waned. However the retail landlord REITs have decoupled from this trade; Scentre Group (SCG), Stockland (SGP), Vicinity Centres (VCX) and Westfield (WFD) have all underperformed. These four stocks account for almost half the index, weighing on the sector, but masking this divergence. SCG is now trading at a standard deviation below its multi-year average relative to the market (chart 9).
Telstra also caused its share of angst, announcing a 30% cut to its dividend for FY18. This was a necessary, widely anticipated but nonetheless painful step for the share price, which fell almost 7% for the month. Telstra is also at the juncture of uncertainty, with a declining fixed line business, an unprofitable broadband segment as
companies make a “land-grab” for market share during the NBN rollout and the emergence of a new competitor in the mobile space. We believe that they have cut the dividend to a point where it is sustainable over the medium term, removing further cuts as an issue. It is also yet another blue chip trading well below its historical average (chart 10). For all the negative headwinds facing TLS at the moment, there comes a point where all the negativity is priced in and it does not take much in terms of incremental uptrends to drive a significant re-rating, particularly in a stock which is still yielding north of 6%, pre-franking, even after the dividend cut.
Disruption remains a defining feature of this market. Many businesses face structural and, in some cases, existential challenges as a result of new technology, business models, global competitors, and regulation. This has led to challenges, evidenced in the demise of Australian brands such as Dick Smith and Herringbone. But it is crucial to acknowledge that it has also led to some of the best investment opportunities over the past two years; our best calls in recent times have included Qantas (QAN), Nine Entertainment (NEC), Metcash (MTS) – companies in challenged industries that have been periodically mispriced.
Chart 10: TLS 12m forward P/E relative to ASX 200 industrials
9
Reporting Season Wrap & Outlook
Chart 11: ASX200 ex-Financials FY18 expected relative spend
Feb-
04
Aug
-04
Feb-
05
Aug
-05
Feb-
06
Aug
-06
Feb-
07
Aug
-07
Feb-
08
Aug
-08
Feb-
09
Aug
-09
Feb-
10
Aug
-10
Feb-
11
Aug
-11
Feb-
12
Aug
-12
Feb-
13
Aug
-13
Feb-
14
Aug
-14
Feb-
15
Aug
-15
Feb-
16
Aug
-16
Feb-
17
Aug
-17
Food & Beverages
Mining
Infrastructure
Retailing – Food
Energy
REITs
Divers. Financials
Utilities
Casinos & Gaming
Health Care
Media
Transport Services
Retailing – Non-food
Banks
Building Materials
Insurance
Telecom
-1.5
-1.5
-1.2
0.6
0.6
1.3
3.9
1.2
1.3
4.1
FY18 EPS change
-10 -8 -6 -4 -2 0 2 4 6 8 10
%
Return
4.2
4.8
8.4
9.7
1.6
1.9
-1.4
-1.6
-2.4
-0.2
-0.3
-0.40.1
-4.6
-5
-5.4
-5.6
-7.5
-3.6
-4.4
-3.1
-2.8
-3.8
-4.3
Feb
07
Aug
07
Feb
08
Aug
08
Feb
08
Aug
09
Feb
10
Aug
10
Feb
11
Aug
11
Feb
12
Aug
12
Feb
13
Aug
13
Feb
14
Aug
14
Feb
15
Aug
15
Feb
16
Aug
16
Feb
17
Aug
17
Sep
07
Apr
08
Nov
09
Jan
10
Aug
10
Mar
11
Oct
11
May
12
Dec
12
Jul 1
3
Feb
14
Sep
14
Apr
15
Nov
15
Jun
16
Jan
17
Aug
17
Aug
14
Oct
14
Dec
14
Feb
15
Apr
15
Jun
15
Aug
15
Oct
15
Dec
15
Feb
16
Apr
16
Jun
16
Aug
16
Oct
16
Dec
16
Feb
17
Apr
17
Jun
17
Aug
17
Sep
07
May
08
Jan
09
Sep
09
May
10
Jan
11
Sep
11
May
12
Jan
13
Sep
13
May
14
Jan
15
Sep
15
May
16
Jan
17
Sep
17
Jan
12
May
12
Sep
12
Jan
13
May
13
Sep
13
Jan
14
May
14
Sep
14
Jan
15
May
15
Sep
15
Jan
16
May
16
Sep
16
Kam
17
May
17
Sep
17
3%
2%
1%
0%
-1%
-2%
-3%
-4%
1.5
1.4
1.3
1.2
1.1
1
0.9
0.8
0.7
0.6
1.5
1.4
1.3
1.2
1.1
1
0.9
0.8
0.7
1.5
1.4
1.3
1.2
1.1
1
0.9
0.8
0.7
0.6
1.4
1.3
1.2
1.1
1
0.9
0.8
0.7
0.6
120%
110%
100%
90%
80%
Jan-
95
Jan-
97
Jan-
99
Jan-
01
Jan-
03
Jan-
05
Jan-
07
Jan-
09
Jan-
11
Jan-
13
Jan-
15
Jan-
17
40,000
35,000
30,000
25,000
20,000
15,000
10,000
5,000
0
-5,000
Average = - 0.9%
FY94
FY95
FY96
FY97
FY98
FY99
FY0
0
FY0
1
FY0
2
FY0
3
FY0
4
FY0
5
FY0
6
FY0
7
FY0
8
FY0
9
FY10
FY11
FY12
FY13
FY14
FY15
FY16
FY17
FY94
FY95
FY96
FY97
FY98
FY99
FY0
0
FY0
1
FY0
2
FY0
3
FY0
4
FY0
5
FY0
6
FY0
7
FY0
8
FY0
9
FY10
FY11
FY12
FY13
FY14
FY15
FY16
FY17
Aug-17 -0.4%
0
1
2
3
4
5
6
7
8
9
FCF margin (median)
1.0
1.5
2.0
2.5
3.0
3.5
Net debt / EBITDA (index average)
Median
Source: Goldman Sachs, Factset September 2017
2011 2013 2016 2017
EBITDA Capital expenditure Free cash flow
Source: UBS, September 2017
12 M
onth
forw
ard
P/E
rela
tive
12M Fwd rel P/E -2 STD
-1 STD +1 STD
+2 STD
12M Fwd rel P/E -2 STD
-1 STD +1 STD
+2 STD
12M Fwd rel P/E -2 STD
-1 STD +1 STD
+2 STD
12M Fwd rel P/E -2 STD
-1 STD +1 STD
+2 STD
12 M
onth
forw
ard
P/E
rela
tive
12 M
onth
forw
ard
P/E
rela
tive
12 M
onth
forw
ard
P/E
rela
tive
-4%
-2%
0%
2%
4%
6%
8%
10%
Aug-17 +5.8%
“ Ultimately, accounting earnings can be manipulated, to an extent. Cash flow cannot, and often offers a far more accurate gauge of a company’s true health and fortune.”
Economic outlookWe are more sanguine about the economic backdrop following reporting season than was the case six months ago, for three reasons. The first is that, at this point, the slowdown in housing appears to be orderly and is not providing the headwind to economic growth that some feared. This factor demands close observation however, with employment strong and interest rates low, the backdrop is relatively benign.
The second factor is that we are seeing signs of a material pick-up in capex for the first time in five years (chart 11). There is a balance to be struck here, as it has been capex discipline which has allowed companies to generate cash flow, de-risk balance sheets, and increase payouts in an otherwise sluggish environment. Some of this is also not productive from a shareholder’s perspective, such as the increased cost for some companies to counter negative public perceptions or government pressure. Nevertheless, signs that companies are starting to spend provides a tailwind for the broader economy that we have not seen for some time.
The third component is the pipeline of infrastructure as governments roll out a programme of road, rail and metro projects (chart 12). This has been well telegraphed and has a long-lead time but there are now signs that we are moving into a significant uplift in spending. This is coming at a point where mining companies are no longer scaling back on investment, providing a tailwind for employment and activity which, again, has been missing for some time.
Source: Credit Suisse, September 2017
Chart 12: Value of work done by year (years ended June)
10
Market outlook The S&P/ASX 200 rose 5.2% over the twelve months to the end of August, which was in line with our expectation of mid-single digit returns. This was driven by earnings, which rose 9.3%, rather than by valuation re-rating. While earnings growth was almost entirely from Resources, Financials was the only broad sector to re-rate, contrary to the expectations of many.
From here, we expect more of the same; a mid-single digit return, driven by earnings. The market’s valuation has remained reasonably consistent at around 16x next-12-month P/E. This is a touch higher than the long-term average but is consistent with the low level of interest rates, which can sustain a higher rating. A reasonably cautious unwinding of European quantitative easing and only marginal tightening from China means that liquidity is not a headwind. The market is also enjoying support from the significant yield premium it enjoys over bonds. At this point, with little sign of recession and absent some geopolitical shock, we see the market able to hold its valuation rating. This leaves earnings as the market driver, with consensus expectation of 7% growth for FY18.
Crucially, we believe we are at an inflection point in Australian equities. The dominant trend of recent years – falling bond yields which fuelled a surge in defensive yield and growth stocks – has waned and bond yields now look range-bound. Chinese policy remains supportive of resource stocks, but is no less opaque than in the past
and its future direction rests on the political transition in October. Oil prices likewise look range-bound, with Saudi Arabia’s efforts to cut production and raise prices nullified by production increases from non-OPEC countries. At the same time, we have a market facing unprecedented disruption in the form of new technology, competition, and regulation which is providing structural challenges to long-standing Australian oligopolies.
In short, uncertainty abounds. Themes and trades which have been “one-way” in recent years are no longer. Many companies which have done well are looking challenged. As active managers, this is a fertile environment. Uncertainty creates mis-pricing – and mis-pricing creates opportunity. In this environment there will be divergence between sectors and, crucially, divergence between companies within the same sector. This is where the ability to scour the entire market for opportunities comes to the fore. This is where the opportunity to meet management, gauge their strategy and quality, and to assess their ability to navigate a tricky environment become crucial for an investment outcome. We remain mindful of the challenges and cognisant of the uncertainty, however we believe that our bottom-up, fundamental approach employed by one of the largest teams in the Australian market, is positioned to do well.
“ Uncertainty creates mis-pricing – and mis-pricing creates opportunity.”
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